Corporate Governance

• The Principal-Agent Problem is managers pursuing their own goals at the shareholders’ expense
• The agent has more information than the principal, leading to adverse selection and moral hazard.
• Type 1 Agency Problem is conflict of interest between the shareholders and management
• Direct Agency Costs are corporate expenditures that benefit managers (e.g. private jets) & the expenditure required to monitor managers (e.g. payment of auditors)
• Indirect Agency Costs are lost business opportunities due to short-termism and lack of risk-taking or effort.
• Type 2 Agency Problem is conflict of interest between controlling and minority shareholders, e.g. dividend distribution when in need of cash
• Single Board of Directors - elected by shareholders with executive and non-executive (independent) directors
• Two Board of Directors - shareholders elect a supervisory board that represents the firm's interests and elects the management board itself.
• The effectiveness of a board depends on its independence, size (the free-rider problem), over-boarding (successful directors sit on too many boards) and the frequency of elections.
• Boards can be monitored through proxy votes, dividends or auditors.
• Proxy votes enable outside groups to lead a campaign to replace the current management by obtaining votes via proxy and starting a proxy fight.
• Dividends can be a form of discipline to limit the cash available to managers.
• Managers often have an economic incentive to increase shareholder value, as managerial compensation is tied to financial performance. It is often presented in the form of equity at a bargain price.
• Bank-based financial systems - banks are the major source of funding for organisations. This facilitates more active monitoring but also means managers have longer horizons and may be less willing to take risks.
• Market-based financial systems - financial markets are the main financial intermediary. This allows for more efficient company funding but may create short-termism due to overemphasising profits.
• A country with a high ratio of domestic money deposits to stock market cap is a bank-based financial system.
• Characteristics of a sole proprietorship are owned and managed by one person, easy to form, profits are taxed as personal income, unlimited liability, life of company linked to life of owner and funding is limited by owner's wealth
• A partnership is easy to form, requires a partnership agreement, has limited and unlimited partners, is terminated when a partner dies or leaves, is difficult to raise cash and is controlled by general partners.
• A limited corporation requires articles and memorandum of incorporation, has limited liability, profits are taxed at the corporate tax rate, has a board of directors and the life of the firm is unlimited.
• CEOs may be incentivised to time earnings announcements to increase the value of options. For example, when options are granted at-the-money (the exercise price is equal to the stock price), there is an incentive to release bad news just before the option is granted.
• Articles of incorporation contain information regarding the company name, business purpose, intended life and number of shares.
• A memorandum of association sets out the process for electing directors and other rules and procedures.